Rookie Corner : The Technical Tango Part II

We are back in the ring for another round!

Last week we left off at the beginning of candlesticks. We looked at the candlesticks themselves so that we could begin to understand what information they can give us. The candlesticks tell us the high, low, opening and closing prices for the day. This is the mechanical definition of a candlestick, however, this definition does little for us. We could define every term in the world of trading and that wouldn’t tell us how to use those items to profit. We need to understand how these items relate to the process of trading so that we can put ourselves in a position that will give us the best opportunity to profit. We need to know the definition of a trading term but understanding how to use them is infinitely more important.

So, now that we know how to read the candlesticks lets see if we can make more sense out of the patterns that a collection of candlesticks make. An individual candlestick gives a little bit of information but it really doesn’t tell us the whole story. When we start to put a few candles together patterns start to emerge that give more meaning to what we are seeing. For example, if three candlesticks form together in the right way this can form a pivot and can mean the current trend could be changing. Look at the picture below to see what a pivot looks like and what it means for in the bigger picture. If you look at the shaded areas you can see that when we have three candlesticks in a row that are positioned in a certain manner that it can signal a possible change in direction. These two shaded areas are called pivots and they signal the change of a trend. That trend can be a short-term trend, an intermediate trend or a longer-term trend depending on how many candles are in between the pivots. That brings us to the concept of trends in technical analysis.

Trends are basically consistent movements in a particular direction. We can have an uptrend, a downtrend or no trend at all which is called consolidation. Now, if we are looking at an uptrend there are basic characteristics that define what constitutes an uptrend. That would be a series of higher high prices and higher low prices. See the chart below to get an idea of an uptrend. You can see that I have circled both the higher high prices and the higher low prices as well, this is the classic definition of an uptrend and we use this when we are looking at bullish trades. The conservative route for trading dictates that you look for bullish trades in uptrending equities and bearish trades in downtrending equities. There are a lot of counter-trend traders out there but that is a skill that needs to be developed as your trading experience grows. When you are new to trading you want to put as many things in your favor as possible, for instance, you want to ensure that the trend is the same as the type of trade you are putting on, you also want to ensure that the pattern of candlesticks that you are looking is appropriate for the trend you are watching. There are always trades on both sides of the market but it is easier to go with the flow. Think of this concept this way, is it easier to push a boulder uphill or downhill? I think we can all agree that it is easier to push a boulder downhill and this is what we are doing when we put together multiple blocks of technical analysis, like the trend, the pattern, and the overall sentiment of the market.

A downtrend is the opposite of an uptrend, no real revelation there. A downtrend is a series of lower highs and lower lows. Look at the chart below to get an idea of a downtrend.

Trends can continue indefinitely and can also reverse at the whim of the market. Typically there are clues as to when a trend might be changing. That brings us to the phases of a market. There are three phases to any market. Those phases are consolidation, a breakout to the trend and then usually a blowoff before the end of the current trend. Now, not all equities and markets go directly from phase to phase to phase. Sometimes you may get an equity that will go from consolidation to a breakout to the trend and then back into consolidation and then later back into the trend and then a blowoff. Consolidation is characterized by a sideways trending movement. A breakout to the trend is characterized by the formation of the higher highs and higher lows that were mentioned in the uptrend. Then finally the blowoff is characterized by a very steep extreme price movement in conjunction with higher than usual volume. The important thing to understand is that by looking at the price chart you will be able to know when a change is coming if you train your mind to see what the candles are telling you. Take for example the downtrend above, if that put in a higher low instead of a lower low, would that be a signal that maybe things are changing? The simple answer is yes. We need to watch for changes in the formation of candles and trends to let us know when things are different. Below is a chart that shows the 3 phases of the market, this is the same chart of the same equity and it shows in a very short time frame all the phases. We will use this information to give us an edge.

In the above chart, you can see consolidation phase in white, the trend phase in red and the blow-off is circled in green and shows massive volume and a huge candle and then reversed to the downside. This is all part of technical analysis and can help us create higher probability setups for our trades.

Next week we will continue on with technical analysis and we will dive deeper into the concept of support and resistance, this is one of the most important concepts in technical analysis and we will ensure that we have a solid understanding of this concept and then we can start to put the pieces of the puzzle together. In addition to the support and resistance discussion we will talk more about familiar repeating patterns of candlesticks that we also need to train ourselves to recognize. These are more pieces to the puzzle.

Until next time…..Stay technical